Archives For materiality

Corporations sometimes pollute rivers, destroy forests and generate dangerous gases without reporting any of the costs that such errant behaviour may ultimately incur. The UN has explained why business managers should consider the effects of their decisions not only on finance, but also on social systems and natural capital.

Business decision models must recognise how those decisions will affect natural capital, despite the effects not being material on reported profits. ACCA’s recent report, Is natural capital a material issue?is welcome because it highlights concerns about current business decision making practices.

However, attempting to make companies put value on natural capital in their financial reports may not be the best way forward.

Society is structured so that any organisations cannot exist unless they make profits. Managers are aware of this, but most managers might agree that it is wrong to:

Pollute streams and the sea;

Pollute arable land so that little will grow on it

Pollute the air and in so doing affect people’s health

Add to the world’s carbon emissions

Add to global warming

Add to ozone depletion

Destroy forests

Destroy fish and other natural food stocks

Drive species of plants and animals to extinction

Pass onto the next generation a degraded natural environment.

Depleting or destroying natural capital in these ways usually results from business activities undertaken to increase profits. While the ACCA report suggests that in accounting terms ‘a material issue is largely defined as one that has a significant financial impact on corporate activities’, the natural capital destruction listed above typically never appears in financial reports; it is invisible to people who are trained to view the world financially.

It is interesting to examine the efficacy of financial reports in discharging their more traditional role. The 2011 working paper of the International Integrated Reporting Committee, referring to financial reports observed: ‘The small percentage of market value now explained….down to 19 per cent in 2009 (for the S&P 500) from 83 per cent in 1975. The remainder represents intangible factors…’

Do we wish to introduce further estimates and complications to financial reports? It would be difficult to provide comparable natural capital figures for all financial reports that all interested parties would agree were fair. The ACCA report itself declares: ‘Studies undertaken….showed that corporate reporting on biodiversity is largely qualitative in nature…’

The argument that what cannot be quantified cannot have influence is an absurd one. A fishing company could decide not to fish within the habitat of an endangered species. Would it be worth estimating how much the company’s total fish catch declines in value as a result, or what the value of public relations benefits are? Would everyone agree?

Most managers are aware of such disastrous outcomes as those listed above. Surely they will avoid such outcomes, even without valuations, because it is the right thing to do. Or should managers do the right thing only when it can be justified financially? If we cannot trust senior managers to behave responsible, we must re-educate them away from the hegemony of the current market model or suffer the consequences.

ACCA’s report is welcome because it challenges its readers to address an issue that everyone, for the time being, can choose to ignore. The longer the issue is ignored, the more difficult it will become to sustain natural capital. It is undeniable that natural capital is a material issue in our world. It must be recognised as such, and the related problems are quantified and appear in financial reports.

Materiality is defined by the IASB (International Accounting Standards Board) as ‘an entity-specific aspect of relevance based on the nature or magnitude or both of the items to which the information relates in the context of an individual entity’s financial report.’ In other words – it is about making judgements on the significance/importance of the variety of issues that might be considered for inclusion in the financial reporting of organisations – both according to their nature (what they relate to) and their magnitude (how big they are). If something is material to an organisation, it should be reported on, if it is not material, then it does not necessarily need to be.

By its very nature, materiality is an inherently subjective concept, and difficult to set and define. It is quite obvious that making professional judgements on levels of materiality is integral to the financial reporting and auditing process. Consequently, to support practitioners, a number of bodies involved in the accounting sector – standard setters, regulators, sustainability reporting groups – have developed guidance on their understanding and perspective on the concept.

The following table provides some excerpts from guidance/definitions of materiality from such bodies, and their sources. A number of the issues included, and terms used, are similar – but it is worth considering what/who some of the substantive terms in these definitions relate to. For example, who are the ‘users’ of the accounts referred to in these definitions, and what type of information is likely to influence their decisions about an organisation?

Of interest, several prominent sustainability reporting bodies make reference to the interests of wider stakeholders and broader organisational performance (including social and environmental issues) in their guidance – which, in doing so, extends the scope of what might merit inclusion as material issues in financial reporting. More inclusive and wide ranging definitions of materiality will, obviously, have implications for the accounting sector, as practitioners will have to use their professional judgement on issues and topics which may be important to users of the financial statements.

This blog post intends to primarily support ACCA’s Accounting for the future, in particular the session ‘Measuring risk: Material or significant – what it means to me’ on Monday the 8th Of October by looking at some key bodies involved in the reporting and auditing process, and their definitions of the concept of materiality- an issue which will be discussed in greater detail in the session.

Additionally, a number of other presentations during the conference relate to the themes covered in this blog post: